Why Stock Prices in Secondary Matter to Management

I was reading an article at Bloomberg.com yesterday, If Only Everybody Was Paid More. Okay article, mostly even-handed, then I looked at the comments section, and a writer was kvetching about companies didn’t care about their stock price because management had more than enough money to do what they wanted. The stock price did not matter, because secondary trading puts no money into the hands of the company.

I started to write a comment, “You don’t understand the stock market…” but after ten minutes, I realized that I had a blog post, and so I copied it to a file, and am completing it now for my readers, who are far larger, and more intelligent than the comment stream at Bloomberg.com.

The price generated by secondary trading does the following to help a company:

If the price is low relative to net assets or potential earnings, it will attract new shareholders that will angle for change. Those investors will aim for control, or for certain value-enhancing actions like a special dividend, a spin-off, etc.

If management/board thinks the price of the stock is undervalued, they will be among those buying shares in the secondary market, improving the value of the shares for the remaining shareholders.

If management/board thinks the price of the stock is overvalued, they may look at other companies to buy that are reasonably priced or cheap that will make their firm more useful. At that point, their stock is a useful currency for acquisitions.

The stock price also serves as a guide to dividends, as it goes higher, often the dividend will go higher. As the stock price goes lower, the dividend will stay the same, until it is unsustainable. When it is unsustainable, the dividend will drop precipitously or be eliminated. When that happens, the stock price will drop more, but the company’s bonds will rally.

A company with a high valuation and excess cash may pay a special dividend to enhance the value, as Microsoft did in the last decade.

Companies with a high valuation may decide to do a secondary offering if they run across an idea that they want to try internally that will require a great degree of investment.

Corporate bond and loan pricing is affected by the stock price. Typically companies with high valuations get lower rates than those with low valuations.

Note that if stock valuations get too low, investors start to distrust the preferred stock, corporate bonds, and bank debt, in that order.

Also consider the stock options, profit-sharing plans, and any 401(k) match that happens in the corporation. They have a significant effect in motivating employees to do better. As the price rises, so does morale. Vice-versa when the price falls.

To summarize: the price that a stock trades at is very important to a corporation, even if it is not receiving any money directly as a result. In general, the higher the stock price in the secondary markets, the greater the number of financial options that management has, and vice-versa.

Corporate Effects

The stock price matters to defined benefit pension plans, endowments, etc., because it affects solvency and ability to spend. It affects fund managers, because a high market capitalization makes it more painful for them not to own your stock, if they benchmark against an index that the company in question in it.

And, if you get big enough, index inclusion means you get a dedicated bunch of shareholders that aren’t leaving anytime soon. The rewards get bigger until you get into the Holy Grail, the S&P 500.

Conclusion

So, yes, it does matter what the stock price is to a corporation, even if the company does not receive any money as a result of the trading.

About the author

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately.
From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies.
Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.
From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that.
Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog.
I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.